Market Spread in Crypto
The financial market, whether it's stocks, bonds, or crypto assets, operates on the principle of supply and demand. Sellers aim to sell their assets at the highest possible market price, while buyers strive to purchase at the lowest price. This tug-of-war between buyers and sellers creates a gap between the bid (offered price) and ask (requested price), known as the “spread”. The spread is essentially the discrepancy between the selling price and the purchase price of an asset, also referred to as the bid-ask spread.
Another important concept related to spread is slippage, which is the difference between the price at which a trade was placed and the price at which it was executed. Two major factors contribute to slippage — liquidity and volatility. Typically, an asset with high liquidity has a lower spread, while an asset with low liquidity has a higher spread.
It is worth adding that high trading volume typically leads to a smaller spread due to increased market liquidity and competition. However, in periods of high volatility, spreads can widen despite high trading volumes. Conversely, low trading volume can result in a wider spread due to lower liquidity and potential price impact from large orders.
For those who are new to the world of cryptocurrency trading, understanding the concept of spread is a fundamental step towards developing a successful trading strategy. This article aims to provide a comprehensive guide on what spread is, how it impacts your trading, and how to mitigate its influence on your trading decisions.
- A discrepancy between the selling price and the buying price of an asset is referred to as a bid-ask spread.
- Slippage is the difference between the price at which trade was placed and the price at which it was executed.
- Two factors are responsible for slippage - Liquidity, and volatility.
- Typically, when an asset has high liquidity, the spread is lower. When it has low liquidity, the spread is higher.
What Is a Spread?
Delving deeper into the concept of spread, it represents the difference between the asking price for an asset and the price another party is willing to pay for that same asset.
For instance, if you're negotiating a deal to purchase Bitcoin from someone, you might offer to buy one Bitcoin for $30,000. However, the other party might believe it's worth more and ask for $31,000 instead. In this scenario, the crypto spread, or Bitcoin Spread, is the difference between your $30,000 bid to purchase Bitcoin and the other person's $31,000 ask price.
When this scenario is applied to a cryptocurrency exchange, the order book represents the willingness of hundreds or even thousands of participants to purchase or sell an asset (like Bitcoin) at a specific price. Understanding how spreads work is crucial not only for comprehending the market depth, but also for avoiding an often-overlooked cost associated with trading.
To understand how spreads are formed on an exchange, one can observe the trading terminal. The terminal displays asset quotes in a special table — the order book. It shows the sale and purchase prices of a particular asset within trading pairs. The part with the prices slightly lower displays the buyers’ offers (usually colored green), while the part with higher prices contains the offers made by sellers (colored red).
The order with the best ask price is placed at the bottom row of the sellers’ red half of the table, and the best bid price — is in the top row of the buyers’ green half. The difference between these two prices is the spread.
New orders with the best prices shift the existing ones in the order book. The orders placed earlier are executed and leave the order book during the trading process. As a result, the ask and bid prices, including the best ones, are in constant motion, which leads to changes in the spread.
The spread on the exchange can be several thousandths of a cent or several tens of cents. To ensure market liquidity, maximum spreads are usually set on exchanges. The smaller the spread, the more liquid the asset is, and vice versa.
Arbitrage Trades Spread Is Usually Used In
Spread is commonly used in arbitrage trades. A spread trade is the simultaneous buying of one asset and selling of another, usually on options or futures. The two parts of the trade (selling and buying) are commonly referred to as “legs”. Spread traders try to profit from the widening or narrowing of the spread, but not directly from the price fluctuations of the asset. There are three basic types of spread trading:
There are three basic types of spread trading:
- Calendar spread trading: traders try to benefit from the difference between the expected market performance of an asset or derivative on two certain dates;
- Inter-commodity spread trading: trading two economically comparable cryptocurrencies;
- Option spread trading: this strategy involves the trader picking two varying options as different 'legs'. Both options have to be related to similar security.
Important Elements of Spread Trading
Investors often prefer spread trading when they need to hedge the risks of one asset against another tokens or derivatives. However, thorough research should be made on both digital currency, futures, or options that you will use in spread trading. Remember, you need to choose two instruments between which there is an inherent connection.
Choosing the Right Tools for Effective Spread Trading
When engaging in cryptocurrency trading, a crypto wallet is an essential tool. It is considered to be a safer option for storing your funds than an exchange. The speed and efficiency of your wallet can impact your trading activities. For instance, if there's a significant market spread, and you spot an opportunity to trade, the transaction speed of your Bitcoin wallet could be the difference between capturing that opportunity or missing out. Therefore, choosing a reliable and efficient wallet is an important consideration in minimizing potential trading delays and maximizing the effectiveness of your trading strategy in volatile markets.
Types of Spread
There are several types of spread on the cryptocurrency market:
- Inter-exchange spread — the difference in prices of the same asset on different exchanges. Its value is important for traders who use arbitrage strategies;
- Intra-exchange spread is the difference in prices of related or deeply correlated assets on the same trading platform. This includes, for example, the price difference between BTC and WBTC;
- The calendar spread is one of the varieties of the intra-exchange spread that exists in the futures market. It reflects the difference in prices of contracts for the same underlying asset, but with different expiration dates.
What Is Crypto Market Spread?
The spread of the cryptocurrency market is not fundamentally different from the spread of the stock market. It also represents the difference between the buy order price and sell price of an asset. In this case, all assets are cryptocurrencies and their derivatives. Crypto exchanges are also traded through the order book, where the spread can be tracked.
How To Calculate Crypto Market Spread
Let’s run through an example of how to calculate market spread using the ETH/USD pair on the Redot exchange.
To calculate the crypto market spread, you need to subtract the highest bid price (HBP) from the lowest ask price (LAP). For example, if the lowest ask price for ETH was $1612.35, and the highest bid price for ETH was $1611.66, the spread would be $0.69.
LAP - HBP = Spread
Spread = $1612.35 - $1611.66. = $0.69
If you want to calculate the spread in percentage, you will subtract the HBP from the LAP, divide the result by the LAP, then multiply by 100.
Spread percentage= (LAP-HBP / LAP) x 100
- LAP is the lowest ask price
- HBP is the highest bid price
- 100% to convert the result to a percent
Percent Spread = (0.69 / 1812.35) x 100 = 0.038%
This is the typical way to calculate the spread on the crypto exchange. To address some other use cases though, let’s look at how to calculate variable and fixed spreads that are often employed by a crypto brokerage/middleman charging extra fees for facilitating transactions.
How Does The Market Spread Impact Crypto Trading?
Your trading approach may perform well or poorly depending on the market spread. Many traders only think about how the trading fees will affect their performance. Some traders will realize, after giving it some more attention, that the market spread can have a bigger impact on performance than the trading fee. To make sure your trading plan is profitable, you must consider the impact of the market spread while putting it into practice.
Let’s use the Ethereum coin and Redot bid/ask spread as an example. If ETH's lowest Ask price in a Redot order book is $1800 and the highest bid price is $1770, the Redot spread here is $30. And using the calculation given in “how to calculate market spread”, the spread percentage is 2.31%.
If the spread does not change, any trader that places a buy order at the $1800 price will have bought the ETH at a 2.31% premium compared to if he placed a limit order at $1770 and waited for a fill. A 2.31% market move isn’t negligible.
If, for instance, ETH is on a bullish run from $1800 to $1900, and the trader wants to take a profit, he would pocket only $100 instead of $130.
In order to maximize gains, we must consider the spread when placing a trade. From a theoretical standpoint, it could seem to be far simpler to make money on an asset with a small spread than one with a widespread because the directional move of the asset must be more significant when the asset was purchased more expensively due to the wider spread.
However, the assets with wider spreads tend to be more volatile than the assets with tight spreads. And on volatile markets, higher price swings are to be expected.
However, the assets with wider spreads tend to be more volatile than the assets with tight spreads, hence higher price swings are to be expected.
What Is Slippage?
In basic terms, slippage is the difference between the price when a trade was placed and the price at it was executed. It is a volatility and liquidity-induced phenomenon that can is typically represented in its percentage or dollar value. For example, if Aave token was trading at $70 when you placed a buying request but due to increased demand, the order was executed at $72, the 1% or $2 change in price is the power of slippage.
What Causes Slippage?
The next question to ask is, what causes the price of your purchase to be executed at a different price from the placed price? Slippage is not a price error, as it is commonly perceived by new traders. Two things are responsible for slippage - liquidity, and volatility. The former has to do with the number of participants in the market, while the latter has to do with the buying and selling pressure on the asset.
The Importance of the Spread
For long-term investors, the size of the spread will have little effect on profitability, because over a long horizon, the quotes will change many times. However, for short-term traders, it's crucial to take the spread into consideration. Monitoring the value of the spread allows for determining the expected profit from the transaction. Placing limit orders helps to decrease spread risks, especially if you are planning to trade in large volumes and not the most liquid asset. In this case, buying or selling with the market order can significantly affect the average price due to slippage.
How Do You Calculate Crypto Spread?
Spread = Ask Price - Bid Price. Let's say you want to buy Ethereum (ETH). You go to the Redot exchange trading terminal and at the top, in the order book, you see that the bid price is $1300 and the bid is $1270. That means the spread is $30.
How Do You Reduce the Spread of Crypto?
It is impossible to influence the spread value, but there are ways you can reduce costs:
- Use the most liquid assets with the highest volumes, for them the difference between the ask and bid prices is minimal;
- Trade at the time of maximum market activity;
- Do not trade at the time when the most important news comes out, as the spread is likely to be larger.
Is Slippage the Same as a Spread?
No. The spread is the difference between the sellers’ and the buyers’ offers. Slippage is the difference between the amount the trader expects to pay or receive and the actual price the trader pays or receives. The actual price may change due to volatility in the market or the lack of liquidity.
Are There Spreads on Crypto Trading?
Yes. The spread is not only inherent in the stock market but is also part of cryptocurrency trading.
What Is the Role of Market Makers in Market Spread?
Market makers are instrumental in shaping the market spread. They ensure market fluidity by continuously offering to buy or sell assets. The gap between their buying (bid) and selling (ask) prices forms the market spread. Their profit comes from this spread, as they buy at lower bid prices and sell at higher ask prices. While they facilitate swift trade execution and help stabilize price volatility, they also bear the risk of holding assets, adjusting the spread as a risk management strategy.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.